Is Microsoft Bottoming Out? - Part 1

The Vanity Fair article's premise and conclusion is that Microsoft has lost its edge in the last decade by myopically placing too much emphasis on Windows and Office to the detriment of emerging technologies like tablets and e-readers. Microsoft is now, in the words of Kurt Massey, a former senior marketing manager quoted in the article, "a barren wasteland." The article does make some valid points, but what it fails to do is present a complete picture.

It's been a busy summer for Microsoft and chief executive Steve Ballmer.

In recent weeks, the software giant released customer previews and ship dates for the newest
versions of its flagship Windows and Office products; purchased Yammer, a cloud-based
enterprise social networking company; hosted its annual Worldwide Partners Conference (WPC)
in Toronto; and vocally signaled its intent to leave no stone unturned in competing head-on with
rivals Apple and Google.

Sounds good, right? Unfortunately all of these positive moves are overshadowed by three things:

Microsoft reported the first quarterly loss in its 26 years of being traded as a public
company. Slipping into the red for the first time in nearly three decades, Microsoft has
reported a loss of US$492 million in the June quarter. Most worrisome is the reason for the
loss. Microsoft took a non-cash write-down of $6.2 billion related to non-performance of
online advertising business and Internet services division aQuantive, which it
acquired in 2007. On a positive note, revenue for the fourth fiscal 2012 quarter rose 4
percent to $18.05 billion, compared to the $17.36 billion sales Microsoft posted in the
same period a year ago.

Vanity Fair magazine published "Microsoft's Lost Decade," a scathing profile by contributing Editor Kurt Eichenwald. In it, Eichenwald makes a case that
Microsoft has spent the last 10 years unsuccessfully dithering in several key market
segments including smartphones, search, social networking, mobility and tablets,
falling far behind competitors like Apple and Google.

Windows 8 is being dubbed a "disaster" in some quarters -- three months before its
scheduled October ship date.

What goes on here? Whoa. Are things really as bad as all that? Is Microsoft doomed to suffer a
quick decline, inexorably marching off to a high-technology elephant's grave yard? Not so fast.

Microsoft is in transition and does face significant challenges to both its business and technology
model going forward. However, it still has a lot going for it, and rumors of its demise are premature.

In Part 1 of this two-part column, I'll examine the perception and reality of the challenges
confronting Microsoft. In Part 2, I'll detail its strengths.

Microsoft's Financials

As for Microsoft's current financials, the company does suffer by comparison to rival Apple -- but so does just about every other company on the planet. Apple's success and phenomenal growth surge has outpaced just about every corporate measurement over the past six years, thanks to the iPhone and iPad.

Apple aside, Microsoft's financials are more than respectable, as shown in Table 1 below.
It has one of the highest market capitalizations in the industry, at more than $247 billion. Annual income is $23.34 billion on sales exceeding $73 billion.

The rest of Microsoft's balance sheet is equally clean, with profit margins of close to 32 percent and
operating margins of 38.44 percent. The company also has $58.35 billion in cash, while total debt is a
manageable $13.15 billion. These figures enable Microsoft to pay shareholders a 2.7 percent dividend.
In March, Apple announced it would pay its first quarterly dividend in 17 years -- $2.65 per
share, beginning July 1.

Microsoft derives 35 percent of its revenue from Office, 22 percent from Windows, and 10 percent from its Xbox business, with the remaining 33 percent spread out among other products and services.

Clearly, Microsoft has a lot riding on the fall introduction of the new Office and Windows releases.
Flagging PC sales are hurting all the OEMs, including Apple. And just as clearly, Microsoft must do
something quickly to either jump-start its lagging Internet and online advertising and smartphone
sales or admit defeat and cut its losses.

Based on Steve Ballmer's comments at the Worldwide Partners Conference (WWPC), in which he vowed to take on Apple, failure is not an option.

Microsoft by the Numbers

Source: Capital IQ

Market Cap:

$247.32B

Revenue:

$73.03B

Net Income:

$23.34B

Profit Margin:

31.97 percent

Operating Margin:

38.44 percent

Return on Assets:

16.12 percent

Return on Equity:

38.23 percent

Qtrly Revenue Growth:

6.0 percent

Qtrly Earnings Growth:

-2.40 percent

Total Cash:

$58.35B

Total Debt:

$13.15B

Bottom line: Most corporations would kill to have Microsoft's balance sheet.

Vanity Not So Fair

The
Vanity Fair article unflatteringly compares Microsoft's financial performance to Apple's, noting that one singular product, the iPhone, now generates more revenue than all of Microsoft's products combined.

The article also uses interviews with named sources -- including former
Microsoft engineers and product managers -- to paint a highly critical analysis of Microsoft's
internecine conflicts and counterproductive corporate practices, such as stack ranking reviews.

The article's premise and conclusion is that Microsoft has lost its edge in the last decade by
myopically placing too much emphasis on Windows and Office to the detriment of emerging
technologies like tablets and e-readers. Microsoft is now, in the words of Kurt Massey, a former
senior marketing manager quoted in the article, "a barren wasteland."

The Vanity Fair article does make valid points, but what it fails to do is present a complete
picture that details Microsoft's financials, illustrates what Microsoft has done right over the last
10 years, notes what it continues to get right today, and acknowledges where it is well-positioned for the future.

Microsoft Missteps and Vulnerabilities

The most worrying current Microsoft statistic is that its quarterly earnings growth is off 2.40 percent
year over year (YoY), reflecting slowing PC sales, which also negatively impacts Microsoft's
core Windows and Office products.

To reiterate, Windows and Office combined account
for 57 percent of Microsoft's overall revenue. It's no secret that both Google and Apple have been
launching an assault on the company's traditional bailiwick among corporate enterprise
customers. It's also no secret that due to changing market dynamics and the continuing economic
downturn, Microsoft has felt the pain and pressure of getting users to upgrade to new
versions of Windows and Office.

Windows 8 and Office 15 are both due to launch this October. Exact ship dates and pricing have
not yet been released. While many industry observers have already declared the PC dead, that is
an overstatement.

Tablets, most notably Apple's iPad, are certainly cropping up more and more
in businesses, but enterprises are in no way ready to chuck their PCs and notebooks in the near
term or intermediate future.

That said, the market is evolving, and Microsoft must embrace the
new form factors and be in the forefront of innovation with its upcoming Surface tablet -- though
there is bound to be some disruption from disaffected OEMs.

Other well-documented Microsoft product market missteps:

Smartphones and Mobility: This is a case of too little, too late. Windows Phones from Nokia and others are decent products, but they were woefully late to market due to delays
in Microsoft's development process. By the time these products shipped. Apple's iPhone
and Google Android-based devices had built up an insurmountable lead. Microsoft is
also hobbled by its partnership with Nokia, whose sales and market share are in free fall.

Search: From a feature/function standpoint, Microsoft's Bing is a terrific search
engine that has about 11 percent market share. But again, Microsoft's tardy entrance into the
search engine market allowed Google to build 65 percent market share that will be difficult, if
not impossible, to overcome.

Microsoft Company Morale and Stack Ranking

In the late 80s, 90s and through the early 2000s, jobs at Microsoft were highly sought after.
Microsoft made lots of millionaires. In the last 10 years, Microsoft's stock has stagnated. In the
last year, the stock has ranged from a low of $23.79 to a high of $32.95. Its current price of
$29.58 is on the higher end of the 52-week range, but the stock price is sluggish and shows no
signs of breaking out of the slump.

A good portion of the Vanity Fair article was devoted to Microsoft's practice of stack ranking. Stack ranking undercuts morale and causes many loyal workers to seek
employment elsewhere. Stack ranking is exactly what its name implies: In a team of workers,
it's predetermined that a certain percentage will receive excellent reviews, the majority will get
a middling/mediocre review, and a remaining small percentage -- roughly 10 percent -- will get a
failing review, causing them to be put on probation or even terminated.

Microsoft employees
are upset -- and rightfully so -- that the ranking system mandates certain numbers of people will
excel while others are doomed to be assigned a failing grade, whether they deserve it or not.

To put it bluntly, stack ranking is rank! Whoever had this idea ought to get an "F" in his/her next
performance review, because it stinks. It certainly does nothing to motivate workers, and in fact it
could damage their performance. Microsoft needs to cancel stack ranking immediately.